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APR,14

06

Fixed Income Leonid Sopotnitskiy

The objective of this article is to give a brief overview of CDS pricing and the methodology of calibrating the default probabilities to the real market.

A sample spreadsheet with respective calculations is included.

Credit Default Swaps (CDS) are usually quoted in terms of a basis point spread, which virtually indicates the markets view on the riskiness of the

reference entity. The swap deal represents an exchange of cash flows forming 2 payment legs. One paid by the protection buyer on a regular basis is the

premium leg, and the other is the default leg, where payments occur only in case of a default event. A fundamental concept for CDS pricing is that a CDS

transaction has a zero NPV at inception for the deal participants. This means that the present value of the premium leg (PL) and the default leg (DL)

must be equal. And this is where we analyze the CDS term structure and derive the hazard rates from each tenor, because default probabilities are

inferred from them, which basically allows us to calibrate the pricing model to the market. The following system of equations shows the formation of leg

prices, whereas the spread represents the relationship of the DL and PL:

where P(T) is the survival probability at time T, DF(0;T) is the respective discount factor calculated form the spot risk-free interest rate curve. The question

is how to calculate the PVs since both legs have uncertain cash flows? Premiums are paid up to either the credit event or maturity of the swap, whereas

the payments of the default leg (1 Recovery Rate) will occur only upon a credit event. This implies that we will require a grid of credit event probabilities,

payment cash flows and discount factors in our calculations. The discount factors can be derived using the following formula:

The next step is to solve for the survival probabilities and hazard rates () that virtually represent a default probability per period, provided the reference

entity has survived all previous periods (P(T_(n-1) )-P(T_n )). Our current example provides a calculated grid of survival probabilities (including historical

series) using a coded function CDS_Survival_Probability(), which can be found in the CDS_Bootstrapping module, in VBA assuming a constant recovery

rate R = 40%, which is usually used by the market. Once this is done default probabilities are easily obtained as 1 Survival Probability (refer to the

sample Excel file for results).

Chart 1 provides the term structure of the default probabilities of 5 underlying entities with the assumption that at T = 0 the reference entity is solvent,

hence PD(T) = 0. The hazard rates are derived by the CDS_Hazard_Rate() function coded in VBA, which uses the following equation:

In order to obtain survival probabilities we can reorganized the CDS pricing equation into the following form:

The above statement is verified by the constructed chart displaying the dependency of default probabilities on recovery rates and tenors (see chart 3).

This chart in general tells us that higher levels of recovery rate induce higher default probability for a given premium this happens primarily due to the

fact that the default leg becomes cheaper (i.e. we assume that the reference entity will be solvent enough to cover more losses) at a fixed spread and

hence the conditional default probability increases.

The results can be applied in relative value analysis when comparing CDS curves with bond data on a Z-spread basis: in order to do this the bond cash

flows will need to be adjusted by the default probabilities; and this plays a major role in adjusting OTC derivative positions to reflect credit risk (CVA/DVA).

This topic is further discussed and illustrated in articles on relative value analysis of credit instruments and pricing basket CDS using copulas

Related articles

2 Comments

MAY,14

30

MAY,14

30

visitor says:

thanks for this invaluable article. wanna see more stuff in regards to the application in busket CDS/CDO pricing using copula from here.

visitor says:

A complete spreadsheet with VBA would be great! the current one looks like extracted partially from a CDS pricing project.

Reply

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